Why Not a Negative Income Tax?

Why Not a Negative Income Tax?

Milton Friedman first proposed the negative income tax in the early sixties.

Republicans have been winning races again, but with a few important exceptions—Wisconsin congressman Paul Ryan comes to mind—they have done so mostly by running against proposals by liberals in power, rather than by suggesting a coherent alternative agenda. This essentially critical approach contrasts markedly with the 1980s, when the Reagan Revolution worked to implement a rich body of policy ideas developed in advance by many thinkers, including, prominently, the free-market economist Milton Friedman. Friedman, a Nobel Prize winner who died four years ago and whose centennial we will celebrate next year, was one of the most influential economists of the last century. His emphasis on monetary stability as a prerequisite for growth transformed the way that central banks around the world did their business, so that even today, after the worst economic downturn since the Great Depression, no government has openly proposed inflationary policies as a response to the slump, as would have been common in a pre-Friedman universe.

But Friedman’s creative policy proposals to reimagine and replace the welfare state—he called these “alternative utopias,” a term he borrowed from his mentor, the Austrian economist and philosopher Friedrich Hayek—have gained far less traction. Both men believed that the best way to fight destructive ideologies like socialism and statism was to offer equally audacious, but effective, solutions to the problems that the bad theories purported to solve. Just Say No was not, Friedman thought, a satisfactory posture in a democratic society.

Republicans would do well to revisit Friedman’s alternatives. The most familiar is the school voucher, which students could use as tuition at any school, public or private, willing to accept them. But one of the most inventive and potentially effective of Friedman’s alternatives to statist bureaucracy receives far less attention than vouchers do. Liberals tend to dismiss Friedman as an extremist libertarian, a blind advocate of selfishness, an enemy of any kind of social help. This was always an absurd charge. In his 1962 book Capitalism and Freedom, Friedman acknowledged that some form of welfare was necessary in capitalist societies and that the state would likely play a role in its provision. The trick was to imagine a very different, radically improved, and more efficient form of welfare—what Friedman’s son, David, also an economist, calls “libertarian redistributionism.” What kind of program could help protect every citizen from destitution without granting excessive power to bureaucrats, creating disincentives to work, and clogging up the free-market economy, as the modern welfare state has done? Friedman’s answer was the negative income tax, or NIT.

The NIT is easy to describe. “The basic idea,” Friedman wrote in a 1968 Newsweek column, “is to use the mechanism by which we now collect tax revenue from people with incomes above some minimum level to provide financial assistance to people with incomes below that level.” Already, he pointed out, no one pays taxes on the first few thousand dollars of income, thanks to personal exemptions and deductions. Most earners pay a fraction of their “positive taxable income”—that is, the amount by which their earnings exceed that first few thousand dollars. In Friedman’s plan, the poor would similarly receive a fraction of their “negative taxable income”—the amount by which their earnings fell short of that level. This direct cash grant would replace all other welfare programs for the poor, which, Friedman rightly observed, were generating a huge bureaucracy and extensive welfare dependency.

But wouldn’t the NIT—in effect, a government-guaranteed income—still be a disincentive to work, just as no-questions-asked welfare benefits were before being reformed in the 1990s? “Any state intervention, any income redistribution, creates disincentives and distortions,” admits Gary Becker, a University of Chicago economist and Friedman disciple. “But if society decides that a certain level of redistribution must take place, the NIT is the best, the most minimally distorting, solution ever devised.” To limit the disincentive, Friedman argued, the NIT should be progressive. Say the government drew the income line at $10,000 for a family of four and the NIT was 50 percent, as most economists recommend. If the family had no income at all, it would receive $5,000—that is, 50 percent of the amount by which its income fell short of $10,000. If the family earned $2,000, it would get $4,000 from the government—again, 50 percent of its income shortfall—for a total post-tax income of $6,000. Bring in $4,000, and it would receive $3,000, for a total of $7,000. So as the family’s earnings rise, its post-tax income rises, too, preserving the work incentive. This is very different from many social welfare programs, in which a household either receives all of a benefit or, if it ceases to qualify, nothing at all. The all-or-nothing model encourages what social scientists call “poverty traps,” tempting the poor not to improve their situations.

Robert Moffitt, an economist at Johns Hopkins University and a leading authority on the NIT, notes another advantage of the program over other forms of state assistance: “No stigma attaches to the NIT.” Everyone fills out the same forms, and no infantilizing government meddles with a household’s food, shelter, and health care, as under the current system. The NIT simply provides the poor with money, which they can use to meet their various needs. Friedman strongly believed that individuals have the capacity to promote their own interests.

Yet another NIT advantage is a freer labor market. No minimum wage would be necessary, since a minimum income would now be guaranteed. This would boost employment: as economists recognize, a legal minimum wage tends to increase joblessness by discouraging employers from recruiting unskilled labor. The NIT would reduce illegal immigration, too. Managed by the IRS, it would apply only to citizens and legal residents, and since it would eliminate welfare programs, aliens would have less incentive to cross the border illegally for government benefits (though local authorities would still have to decide whether to grant them access to schools and hospitals). “From an economist’s perspective, the negative income tax is the perfect design,” Moffitt says. “The only reason an economist would oppose it would be from a strict libertarian perspective—opposition to any kind of government-managed welfare.”

But the biggest advantage of the NIT is that it requires the smallest possible bureaucracy to implement. The IRS already exists; it knows how to assess income statements; and, to run the NIT, it has only to take money or pay it out. No longer would the federal and state governments maintain the sprawling multiple agencies necessary to distribute food stamps, public housing, Medicaid, cash welfare, and a myriad of community development programs. Nor would they need to pay the salaries and enormous future pensions of the public employees who run all these programs. According to a Heritage Foundation study by Robert Rector, Kiki Bradley, and Rachel Sheffield, the federal portion of America’s welfare system cost a staggering $522 billion in 2008, which works out to about $12,000 per poor person aided. Speaking very generally, then, we can estimate that so long as a federal NIT’s average payout amounted to less than $12,000, it would cost less than the current welfare system does. True, replacing Medicaid with a cash benefit would pose great difficulties in America’s current, heavily regulated health-care system, in which private insurance is artificially expensive. One solution would be leaving Medicaid in place and bestowing a less generous NIT; another, which Friedman himself proposed at the end of his life, would be health-care vouchers, which would work along the same lines as school vouchers.

How could such an intelligently imagined and plausible policy have thus far led nowhere? The history of the NIT is, in some ways, as interesting as the idea itself, and it says a lot about the recent evolution of American society.

Initial opposition to the NIT came not from the Left but from the Right. During the 1960s—an era of very different economic conditions from today’s, with abundant manufacturing jobs and extremely low unemployment—Republicans viewed any kind of welfare as suspect. But Friedman’s reputation compelled policymakers to consider the NIT, and in the late sixties, a small empirical test took place. In New Jersey and Pennsylvania, local academic research centers randomly selected about 1,200 households headed by poor, unemployed people. The households were divided into two groups. One group received traditional welfare benefits—food stamps, child support, public housing, and so on. The other group got cash, distributed the way that it would be under an NIT system. Which group would be likelier to try to get back to work? More of these “income maintenance experiments,” as they were called, were conducted during the seventies and early eighties, against diverse social and ethnic backdrops in Colorado, Indiana, Iowa, North Carolina, and Washington State.

The results of all these tests were fuzzy, probably because so many other factors were in play, from the subjects’ family structure to their personal values to the fact that they were aware of the experiments. But if the results were ambiguous, the media coverage was anything but. The press’s rash and superficial reading of the limited data was simply that the cash recipients were in no hurry to find work and that an NIT would never succeed. It thus was no surprise that when Richard Nixon proposed an NIT in 1972, Republican legislators flatly rejected it, seeing it solely as an encouragement for people to stay on the dole. Prejudice and emotion had trumped knowledge.

Yet the experiments bore out Friedman’s trust in the individual, which stands at the heart of the NIT. The most frequent argument used to legitimize in-kind aid, rather than cash assistance, to the poor is that they would squander cash on nonessential things. But the cash recipients in the experiments tended to use their money responsibly to educate their children and to maintain their homes. Further, those who received an NIT of 100 percent were less likely to job-hunt than those with a smaller-percentage cash grant. This finding reinforced Friedman’s argument that any NIT should be progressive. It also supported his controversial view that work incentives mattered, opening the relationship between incentives and welfare to further research. The mounting evidence eventually allowed a Democratic president, Bill Clinton, to link welfare benefits with a willingness to work and sign welfare reform into law.

An unintended—and, for Friedman, unsatisfactory—outgrowth of the original NIT proposal was the creation of the Earned Income Tax Credit (EITC). This credit, a sum sent each year by the IRS to the working poor, resulted from a counterproposal to the Friedman-Nixon NIT by Democratic Louisiana senator Russell Long (son of Huey, the populist governor). The measure passed Congress in 1975 as part of a stimulus package, and it has remained ever since; last year, nearly 26 million people received the credit, costing a total of almost $58 billion.

The EITC may resemble Friedman’s idea superficially, but it is quite different. It doesn’t replace any welfare programs; instead, it adds another layer to them, utterly failing to reduce government bureaucracy. And though it is a cash payment, as Friedman would have suggested, it goes only to the working poor; the unemployed continue to receive in-kind support, such as food stamps. The rationale behind this distinction between the working and nonworking poor is that the tax credit is supposedly an incentive to work—that is, if you work, you get a credit to supplement your wages, but if you stop working, you lose both your wages and the credit. Studies of the EITC, however, have been inconclusive. Employed single mothers do seem inclined to keep working once they receive the tax credit, instead of turning to welfare; married women, by contrast, sometimes stop working once their husbands get the credit on top of their salaries. The alleged incentive to work is thus not a decisive reason to keep the EITC.

Ideally, an NIT would replace not only the country’s welfare empire but also the EITC, ending the current distinction between the nonworking poor, who are assumed to be incapable of making sensible life choices, and the working poor. A system based on an NIT would treat all Americans on an equal footing.

A few years ago, the social theorist Charles Murray, author of the famous mid-eighties book on the pathologies of welfare, Losing Ground, sought to revive the NIT in a different form. In In Our Hands: A Plan to Replace the Welfare State, Murray devised an even simpler and more egalitarian substitute for welfare than Friedman’s. All existing government transfer payments, from Social Security to family assistance, Murray argued, should be replaced with an annual tax-free cash grant to everyone over 21 of $10,000—roughly where the poverty line is for an individual—with the stipulation that $3,000 of that money go toward health insurance and a strong suggestion that another chunk of it be invested in a retirement account (Murray is slightly more paternalistic than Friedman).

Murray’s plan draws not only on Friedman but on another creative economist, Irwin Garfinkel, currently at Columbia University. Thirty years ago, Garfinkel suggested a “demogrant”: upon reaching the age of 20, every American would get a sizable lump of cash from the government, but no welfare support would be available after that point. Liberals rejected Garfinkel’s plan, just as they have Friedman’s and Murray’s, as too libertarian. Conservatives worried, again, that it would discourage work.

The potentially negative aspects of all these proposals require research, but we should always compare them with the existing welfare system, whose problems even many on the left now recognize. As Becker puts it: “These aren’t perfect solutions, but they try to be less imperfect than what we already have in place.”

George Shultz—who, before serving as Ronald Reagan’s secretary of state, was chair of his Economic Policy Advisory Board, where Friedman was a major intellectual force—calls the NIT “a brilliant and unworkable idea.” Why? “The NIT is unworkable not from a theoretical standpoint but from a political perspective,” he says. “The 27 million families who receive the EITC love it” and wouldn’t want to see their tax credit replaced; further, “most Americans believe that nonworking welfare recipients should get programs and not cash.” One more reason: “The bureaucrats who manage the current welfare state like the power it grants them.” Another former Reagan advisor, Martin Anderson—now, like Shultz, a fellow at the Hoover Institution at Stanford—fears that an NIT would simply be added to, rather than replace, existing programs; politicians are better at piling on benefits than at reengineering the state, he points out.

Shultz and Anderson may be right. But it’s worth noting, David Friedman observes, that “the distinction between in-kind welfare and cash grants is not as pristine as it might appear—many welfare recipients already know how to transform in-kind welfare like food stamps into cash.” More important is that in the current era of vociferous and growing opposition to excessive statism, Milton Friedman’s proposal could have new appeal. With governments at the state and local levels risking default because of unsustainable debt, all government interventions could be up for rethinking in the years ahead.

Such a financial disaster is certainly not to be wished for, but as Hayek maintained, free men and women should always be ready to offer their “alternative utopias” in the event of a crisis. “If conservatives really want to return to power and get the American people to embrace change, they need to go beyond negativity and refocus the political debate on bold ideas,” says Becker. “And the negative income tax is the best we have.” A policy agenda that, say, combined school vouchers, health-care vouchers, and the NIT could help a newly empowered Republican Party shape a twenty-first-century America that was freer—and thus truer to its historical roots.